Several offshore jurisdictions have recently introduced new legislation that requires companies and limited liability partnerships registered in their jurisdiction that undertake certain geographically mobile activities to have “adequate” economic activities (also known as “economic substance”). What should businesses with incorporated entities in these jurisdictions be taking note of?
Whilst the instruments developed by the Organization for Economic Co-operation and Development (OECD) to address base erosion and profit shifting (BEPS) are being implemented, some developed countries are still concerned that these BEPS counter-measures do not yet provide a comprehensive solution to the risks that continue to arise from structures that shift profits to entities subject to no or very low taxation.
As a quick recap, the OECD’s BEPS Action 5 on countering harmful tax practices requires substantial core income-generating activities to be conducted in the jurisdiction where preferential tax regime is granted.
Table 1 shows examples of such activities. The work of the OECD’s Forum for Harmful Tax Practices (FHTP) focuses on reducing the distortionary influence of taxation on the location of geographically mobile activities, thereby encouraging an environment in which free and fair tax competition can take place.
Following initial work by the OECD under BEPS Action 5, the EU’s Code of Conduct Group (Business Taxation) (COCG) also put forward guidance in June 2018 to address economic substance matters which jurisdictions must adopt to avoid being included in the so-called blacklist list of non-cooperative jurisdictions for tax purposes. In response, several offshore jurisdictions have recently introduced economic substance legislation.
New Economic Substance Legislation
In recent years, the Economic and Financial Affairs Council (ECOFIN) of the EU has stepped up its efforts to encourage jurisdictions to actively resolve the issues identified by the COCG in the areas of tax transparency, fair taxation and implementation of anti-BEPS standards.
A set of tax good governance criteria have been used to screen EU and non-EU jurisdictions and an EU blacklist of non-cooperative jurisdictions for tax purposes has been created to promote compliance with the criteria.
On March 12, 2019, the ECOFIN adopted a revised blacklist by adding 10 new jurisdictions which either did not commit to addressing the EU concerns or did not deliver their commitments on time.
The revised list now includes the following jurisdictions: American Samoa, Aruba, Barbados, Belize, Bermuda, Dominica, Fiji, Guam, Marshall Islands, Oman, Samoa, Trinidad and Tobago, United Arab Emirates, the U.S. Virgin Islands and Vanuatu.
In relation to fair taxation, criterion 2.2 states that:
“the jurisdiction should not facilitate offshore structures and arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction.”
On June 22, 2018, the COCG published the Code of Conduct (Business Taxation) Guidance on the interpretation of the third criterion (commonly referred to as the “Scoping Paper”) as to the specific measures and conceptual definitions they are expecting jurisdictions assessed against criterion 2.2 to meet.
The Scoping Paper broadly asserts that the expected substance requirements for various geographically mobile activities should mirror those used by the OECD’s FHTP. Many of the affected jurisdictions—including the Bahamas, Bermuda, the British Virgin Islands (BVI), the Cayman Islands, Guernsey, the Isle of Man and Jersey—responded by enacting economic substance legislation effective from January 1, 2019.
The new substance requirements apply only to companies (and other body corporates with separate legal personality) performing relevant activities in the following sectors:
- fund management;
- financing and leasing;
- distribution and service centers;
- holding company;
- intellectual property (for which there are specific requirements in high-risk scenarios).
A legal entity which carries on more than one relevant activity will be required to comply with the economic substance requirements in respect of each activity.
Currently, the Cayman Islands and BVI have taken the view that the business of an “investment fund” is outside of the scope of the economic substance requirements. In its conclusion on the revised list of non-cooperative jurisdictions for tax purposes dated March 12, 2019, the ECOFIN acknowledged that further work will be needed to define acceptable economic substance requirements for collective investment funds under criterion 2.2, and that the COCG will be providing further technical guidance on this issue by mid-2019.
Companies will be required to provide prescribed information on an annual basis to enable the tax authorities to monitor whether the company is carrying on the relevant activities and if so, whether it is complying with the economic substance requirements. In some jurisdictions, there is a six-month window before compliance is required by July 1, 2019.
In general, the legislation includes robust and dissuasive sanctions for failure to meet the substance requirements. The sanctions are generally progressive and include financial penalties, with the ultimate sanction leading to the striking-off of the company from the corporate registry. For example, in Cayman Islands the penalty for not satisfying the economic substance test is a CI$10,000 (approximately $12,000) fine, and then a CI$100,000 fine if the failure is repeated for a subsequent financial year.
Exchange of information mechanisms may be put in place for automatic notifications to be made to the foreign tax authorities regarding any company that is found to be in breach of the substance requirements and in certain other circumstances.
What Businesses are Asking
The following questions often come up in discussions on the new substance requirements introduced by the offshore jurisdictions:
Is it relevant only to EU-headquartered companies?
The new legislation generally imposes economic substance requirements on relevant legal entities which carry on a relevant activity. The substance requirements can potentially apply to any company incorporated in the offshore jurisdiction, regardless of whether they belong to a European multinational group. Each jurisdiction is likely to issue further guidance on the “in-scope” entities.
Can it be argued that the “adequate” number of personnel for a pure equity holding company is nil since it is quite impractical to hire full-time staff in those offshore jurisdictions?
For pure equity holding companies that only hold equity participation and earn only dividends and capital gains or incidental income, the Scoping Paper states the following:
“Pure equity holding companies must respect all applicable corporate law filing requirements in order to meet the substantial activities requirement and it is suggested that they should have the people and the premises for holding and managing equity participation. Since such regimes are provided to avoid double taxation, there should be no expectation of a correlation between income-generating activities and benefits.”
The above position taken by the ECOFIN in relation to holding companies is consistent with the position stated in the BEPS Action 5 final report as follows:
“... to the extent that holding company regimes provide benefits only to equity holding companies, the substantial activity factor requires, at minimum, the companies receiving benefits from such regimes respect all applicable corporate law filing requirements and have the substance necessary to engage in holding and managing equity participation (for example, by showing that they have both the people and the premises necessary for these activities). This precludes the possibility of letter box and brass plate companies from benefiting from holding company regimes.”
Given the above, this is an area that should be monitored closely. It is unclear whether outsourcing the conduct of core-income generating activity (CIGA) to another person would satisfy the new economic substance test. Even if it is accepted, there may be a requirement that the relevant person is able to monitor and control the carrying out of such activities.
A “pure equity holding company” has generally been defined to mean a company that only holds equity participation in other entities and only earns dividends and capital gains. For a company of any investment other than equity participation (e.g. interest-bearing notes), it is likely that it may not be regarded as a “pure equity holding company.” Given this, such company may not be able to avail itself of the reduced economic substance test applicable to pure equity holding companies.
Is it possible to avoid the need to comply with the substance requirements in the offshore jurisdiction by being a nonresident company?
The answer is probably Yes in the very short-term, but it depends on the specific legislation and implementation guidance to be issued by the relevant jurisdiction.
The company must support the claim that it is tax resident outside the offshore jurisdiction by such evidence (e.g. assessment to tax, certificate of tax residence) as is required by the legislation. Also, the possible tax implications (e.g. controlled foreign corporations, country-by-country reporting and withholding taxes) arising from declaring the group holding company as tax resident in another jurisdiction have to be carefully considered.
Similar Developments Elsewhere
Of late, Mauritius has also made major changes to its Global Business License (GBL) regime to address concerns of harmful tax practices, including the elimination of Category 2 GBL, which provides full tax exemption.
Companies receiving a GBL are required at all times to carry out their core income generating activities in, or from, Mauritius by employing, either directly or indirectly, a reasonable number of suitable qualified persons and having a minimum level of expenditure (MLE) that is proportionate to their level of activities.
In October 2018, the Financial Services Commission (FSC) issued certain guidelines on substance requirements with references to minimum employment of one to three personnel and MLE ranging from $12,000 to $100,000, depending on the activities of the company.
Malaysia also issued regulations on December 31, 2018 on the minimum number of full-time employees and amount of annual expenditure for Labuan companies carrying on certain activities.
The minimum requirements range from two full-time employees and annual operating expenditure of 50,000 Malaysian ringgit (approximately $12,000) for holding company activity to four full-time employees and annual operating expenditure of 150,000 Malaysian ringgit for certain insurance activities.
For Labuan companies that do not meet the substance requirements, they would not be treated as carrying on a Labuan business activity and the consequence would be taxation under the normal Malaysian income tax regime. These regulations are effective from January 1, 2019.
It is worth noting that the recent increased focus on economic substance is nothing new. In 2013, before the OECD released its final report on Action 5, the Netherlands had already taken steps to codify its administrative guidance on substance requirements for companies engaged in inter-company financing and/or licensing activities.
Since January 1, 2014, Dutch companies claiming benefits either under a tax treaty or EU directive are required to make a declaration in their annual corporate income tax return whether or not they have met a defined set of substance requirements continuously throughout the year. In cases where one or more of a list of substance requirements are not met, penalties may be imposed and the Dutch tax authorities will spontaneously notify the foreign tax authorities.
Last year, China and Indonesia also revisited their anti-treaty abuse rules. Not surprisingly, the applicant’s substance is one of the key considerations in determining whether it is the beneficial owner of the income.
What’s Next for Businesses?
Clearly, the trend is moving towards requiring more substance as different jurisdictions work together to ensure that profits are taxed where economic activities generating the profits are performed and where value is created.
While the legislation governing the new economic substance requirements are somewhat unclear and the determination of what is “adequate” is highly subjective, businesses may seek guidance from the minimum substance requirements prescribed by countries such as Malaysia (Labuan), Mauritius and the Netherlands.
Businesses should continue to monitor these developments and assess whether their legacy structures and arrangements are sustainable, and develop their “plan B” where necessary.
Chester Wee is the EY Asean International Tax Services Leader and Partner at Ernst & Young Solutions LLP. He can be reached at: email@example.com